Interest rates, Maradona, and the undervalued pound

The partisan nature of the debate about Britain’s exit from the European Union means it is very difficult to find impartial assessments of the UK economy – it tends to be either prospering or constantly on the verge of collapse.

Following last year’s Brexit vote the Bank of England’s Monetary Policy Committee, with governor Mark Carney at the helm, reduced interest rates and pursued a quantitative easing (QE) programme aimed at supporting the economy. But in June there was an abrupt change in tone from the bank, with suggestions that last summer’s interest rate cut might need to be reversed.

And recently we saw the release of official figures for retail sales that were better than most had expected. So should this be seen as adding to the argument that governor Carney was wrong about reducing rates last year and that the Bank of England will have to raise interest rates imminently?

While it is true that the UK has gone from being the fastest growing G7 nation to the slowest, the G7 is a somewhat archaic group of countries, growth rates are volatile, and all members are enjoying an expansion. So this alone probably doesn’t spell the end of UK economic prosperity.

It is also true that higher inflation has squeezed UK consumers’ incomes. But while inflation has been higher in the UK than elsewhere, the majority of the squeeze on incomes was caused by the recovery in the oil price and can be seen around the world.

The latest data continue to suggest that the UK, while not firing on all cylinders, is holding together reasonably well. The June inflation number was lower than expected at 2.6%, echoing a trend which we have seen in other economies over the last few months. That lessens the squeeze on incomes. In fact, we can see this in the recovery in retail sales – because inflation wasn’t as high as expected consumers were able to buy more than expected.

However, we still don’t think the bank is anxious to raise interest rates. Until June, measures of interest rate expectations had shown investors becoming increasingly confident – almost complacent about rates staying on hold. In that context, the Bank of England probably felt it was worth reminding the markets that interest rates can rise as well as fall, in order to avoid a big shock if inflation picked up later in the year.

Mark Carney’s predecessor, Sir Mervyn King, called this approach the Maradona theory of interest rates. This referred to a famous Maradona goal against England where he beat five English players while running in virtually a straight line. Maradona was able to clear a straight path towards goal by signalling to the defenders that he might be about to turn.

In the same way, the Bank of England would rather raise the prospect of an interest rate hike than actually follow through with one. The market reaction may well mean they now have no need.

But even if interest rates remain on hold, we think the pound has room to rise against other currencies because it currently trades on an attractive valuation.

We thought the euro might be this year’s surprise winner among currencies as 2017 started with too much enthusiasm for Donald Trump’s now collapsed policy agenda, while pessimism about political risk in Europe was also rife. Sure enough the single currency is up 10% against the dollar so far this year.

But we are now less than a year away from the next Italian election, with polls suggesting that it will be won by the populist and eurosceptic Five Star Movement. In fact we suspect the election will be called within the next six months and this is likely to weigh on the euro.

Unfortunately though this is unlikely to be in time for Britons’ summer holidays – where the strength of the euro is making holidaying on the continent that bit more expensive.

Guy Foster, Head of Research

Guy leads Brewin Dolphin’s Research team ensuring that a rigorous and exhaustive investment process is employed. He also provides recommendations on tactical investment strategy to Brewin Dolphin’s investment managers and strategic recommendations to the group’s Asset Allocation Committee. Before joining Brewin Dolphin in 2006, Guy was an Investment Director at Hill Martin (Asset Management). Guy has a Masters in Finance from London Business School. He is also a CFA charterholder, holds the CISI Diploma, and is a member of the Society of Business Economists. Guy frequently discusses financial issues with the written and televised media as well aspresenting to the staff and clients of Brewin Dolphin.

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